New directive on interest rate: Tough days ahead for banks?

By Babajide Komolafe
The new directive on interest rate may introduce another dimension to the competition in the banking industry, with possibility of reducing banksâ€™ profitability.

sanusi

Rising from a special monetary policy committee meeting last week, the CBN said banks would now be required to disclose their interest rate pricing model as well as the spread between the lending rate and the Monetary Policy Committee.

This according to money market operators is a smart move on the part of the apex bank which could lead to decline in lending rates charged by banks and also their profits.

Despite the sharp decline in deposit rates in the last six months, lending rates have remained high. On the average deposit rates dropped to 3.0 per cent in Match from 14 per cent in the third quarter of 2009.

This according to the CBN is due to, â€œinefficiency in cost management and unrealistic profit expectations and targets.â€Â The apex bank expressedÂ the belief that this can be addressed if banks are compelled to disclose how they determine (or price) their interest rate

The CBN stated that henceforth, â€œÂ banks would be required to regularly publish and submit their Risk-based interest rate pricing model to the CBN.
In addition, the banks would be required to provide a statement showing the relationship between the MPR and their prime and maximum lending rates.â€

â€œFor the avoidance of doubt, the MPC will not fix lending and deposit rates by fiat. However, every bank will be required to disclose the maximum spread it charges above the MPR to its prime customers and the risk premium it charges between prime and maximum lending rates. The pricing model would also disclose the basis for the spread and principal components covered.â€

â€œThe articulation of the pricing model in this mode and its disclosure to the general public will serve two purposes. First, by providing visibility on relative efficiency of financial institutions, banks will be encouraged to seek profitability by driving down costs and charging competitive rates rather than charging excessive rates of interest.

Second, by explicitly stating prime and maximum lending rates as a fixed spread over MPR, the policy rate becomes an effective tool for driving lending rates up or down as policy stance dictates.â€

Though money market operators expressed optimism on the effectiveness of the policy, they also said a lot depends on the credibility of the MPR and the supervision of the CBN.

â€œThis will force banks to now think about rationale for pricing. Some higher pricing may come down,â€ remarked a seniorÂ bank treasurer andÂ top official of Financial Market Dealers Association of Nigeria, who described the policy measure as a clever one.

Operators also believe that the initiative might make banks to lend to more people especially people they are presently avoiding in their lending activities.

The challenge to the initiative, they said is the MPR, which they pointed out does not reflect market conditions.Â â€œMPR must be market responsive. It does not change as the market changes. The CBN should move it regularly to reflect market conditions,â€ said a money market operator. Another operator said that that banks would take cue from the MPR , â€œIf it swings regularly with market ratesâ€. He said otherwise banks would introduce other charges to increase their profits.
In deed the MPR though the anchor rate,Â does not reflect market realities. And according to bank treasurers even the CBN does not lend at MPR. For example the MPR has been at 6.0 per cent since last year and despite the sharp decline in interest rates, it has remained stable. This rigidity has created credibility problem for the MPR hence it have no influence in the determination of interest rates in the industry.

In fact it was this rigidity and out of touch with market realities that led to the demise of the Minimum Rediscount Rate (MRR), the predecessor of the MPR; and also the ineffectiveness of a similar initiative which pegged banks lending rate at MRR plusÂ four per cent (The tripartite agreement on interest rate of the Joseph Sanusi led CBN).

While introducing the MPR in 2006, former CBN Governor, Professor Chukwuma Soludo stated, â€œMRR which from past experience had not been sufficiently responsive to CBNâ€™s policy initiatives, especially in tackling the problem of excess liquidity in the system.â€

Unfortunately, the MPR seems to be suffering the same defect and this may undo the new initiative to reduce lending rates just like the MRR did.

But because the new initiative is not a directive that banks should peg rates to MPR but to disclose the spread between their lending rates and the MPR, and disclose how they determine the rates, and that is why most operators believe it would work especially if the CBN monitor the banks to ensure whatever they report or publish is the truth.

One implication of this initiative is that it would reveal the relative efficiency of each bank and this would be another basis for competition. If bank the lending rate of bank A is MPR plus 5.0 per cent, and that of bank B is MPR plus 7.0 per cent. This might create a perception problem for bank B, as it might be perceived to be less efficient than bank A.

According to a bank treasurer, the ensuing competition, would compel banks to reduce lending rates, and this he said means â€œtougher days ahead for banksâ€™ profitabilityâ€. â€œSell down most banksâ€™ sharesâ€, he advised.